Operating Corporations (and Other Business Entities) OBE–118, Fall 2004 Professor McKinsey Whether you are an owner, a manager or a third party, the ways in which a business entity is operated can greatly determine your liability and legal rights.

Sole Proprietorship Partnership LLC Common Law; unlimited liability Corporation Limited Partnership S Corp Limited Liability Partnership Law Corporation Professional Corporation “Artificial” entities ; Limited liability; Lots of other constraints Everything good; Little bad Professional LLC ?????

California Business Organizations

Typical Operational Problems Ownership Disputes: Owners of smaller business have disputes and disagreements among themselves Shareholder Disputes: Managers of corporations make decisions that upset shareholders Personal Liability: Owners of corporations lose their personal liability protection

Ownership disputes Very common in smaller business. Often in partnerships and LLC’s, sometimes in smaller corporations. Implications: –If unresolved, often results in end of business because owners often have significant rights to remove their investment, value or property from the business and go their separate way. Ways to avoid: –Have thorough discussions during business creation to establish expected duties, goals, responsibilities etc. –Create operating agreement for LLC’s –Communicate regularly as business matures –Use mediation (or counseling) to bridge gaps –Majority owners should respect rights of minority owners

Shareholder Claims Business Judgment Rule –Duty of Loyalty –Duty of Care Act in best interest of owners Often the managers of a business (board members, executives or managing members) must make decisions that could result in serious harm to the health of the business if made wrong or could be opposed by some shareholders.

Business Judgment Rule Duty of Loyalty - self dealing and opportunity –Ex: Duty of Care – requires informed decision serving a rational and legal business purpose –Ex:

Takeovers and the BJR Takeovers involve an offer to buy the stock of a corporation, replace or change management and perhaps even the corporations name, etc. BOD has a tough situation: shareholder interest (maximize profit?) versus officer and board interest (loss of jobs). Answer: they have to decide in the interest of shareholders and ensure that they satisfy the business judgment rule.

Limited Liability Protection Limited Liability can be ignored by a court, a doctrine called “piercing the corporate veil” Reasons: –Failure to follow formalities –Commingling of assets –Inadequate capitalization –Fraud

LLC’s and Limited Liability To ensure limited liability, establish some procedures like a corporation, i.e., hold meetings of the managers, record minutes, set up separate accounts, keep funds separate, etc…. In short, follow rules and procedures!

Avoiding Liability Follow procedures Do not co-mingle funds Do not under-capitalize Do not go against your conscience or let others push you to doing anything you do not think you should Do not obtain personal benefits through corporate work other than normal compensation and benefits

Agency An “agent” is a representative that can bind a another person, the “principal.” The agency relationship is governed by default duties and rights. It is contractual in nature and thus agents and principals can modify the default terms and agree to other responsibilities. But not all agents are created in a formal contract process

Creating Agency Relationships Agency by Agreement (express agency –Mutual agreement, agency rooted in contract law Agency by Ratification (after the fact agency) –A principal can agree to accept the decision a person made supposedly on their behalf. Agency by Estoppel (implied agency) –A principal can be estopped from denying an agency relationship because of behavior and treatment consistent with agency

Agency by Estoppel An equitable doctrine founded in fairness False agency claim by person Third party believes that person is agent Principal acted in way to cause belief